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In Bitcoin We Don’t Trust

Why finance and treasury departments are keeping their distance from the virtual currency.

24Apr

On a purely abstract level, Bitcoin is ideal. The virtual currency requires no government backing or third-party middleman, such as a clearinghouse or bank, thereby cutting costs; it uses public-key encryption for security; transactions are irreversible, as with cash; and the supply of Bitcoins is systematically limited. In addition, Bitcoin users need not give up copious amounts of information about themselves to trade, as credit card users do.

For businesses, Bitcoin could in theory be used to transmit funds across country or intracompany borders, eliminating the need for traditional bank wires or other automated transfers. And for a nation’s financial system, the use of Bitcoin (or any other virtual currency) could result in many billions of dollars saved from not having to print, transport, and handle a physical money.

But talk to corporate treasurers about Bitcoin, and the conversation quickly turns from the ideal world to mundane reality — to things like settlement risk, security, and price volatility. Can these issues be addressed so that Bitcoin — a digital currency and Internet protocol that enables peer-to-peer payment worldwide — can enter the mainstream?

Business adoption, after all, is critical to Bitcoin. Although many entrepreneurs are starting up companies to facilitate Bitcoin transactions, there is no evidence that acceptance of the electronic currency in nonfinancial industries is anywhere close to accelerating. One of the currency’s big obstacles is the so-called network effect: as with the telephone, the value of Bitcoin or any other virtual currency is dependent on the number of other users using it.

Bitcoin: is it ready for corporate use, or even retail?“Few retailers accept Bitcoin as a form of payment due to the small user base; and many consumers will not consider using Bitcoin until a significant number of retailers accept Bitcoin payments,” noted William J. Luther and Josiah Olson of Kenyon College in a June 2013 paper, “Bitcoin Is Memory.” “Simply put: network effects favor the status quo. … Bitcoin may fail to gain widespread acceptance even if it were superior to existing monies,” warned Luther and Olson.

Birth of a Currency

To achieve critical mass, some experts estimate 10% of businesses would have to accept Bitcoin as a form of exchange. Notable organizations that accept Bitcoin payments include Overstock.com, Zynga, the Sacramento Kings basketball team, and TigerDirect. But many finance and treasury executives are skeptical of the virtual currency, with good reason.

Bitcoin was created on the concept of eliminating the need for trust in an issuing authority like the U.S. government. In a paper outlining the technology behind Bitcoin, “Bitcoin: A Peer-to-Peer Electronic Cash System,” Bitcoin’s anonymous founder(s) described problems with the need for financial institutions to process electronic payments. Transaction costs make small transactions prohibitive, for example. “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party,” the founder wrote.

(The identity of Bitcoin’s founder(s) has always been a mystery, and at press time there was still much controversy about a Newsweek story that claimed to have identified him — a 64-year-old California man with a computer engineering background. The man has denied any involvement with Bitcoin.)

Thus Bitcoin was born, with unregulated exchanges providing buy and sell bids and people and businesses buying Bitcoins for cash, then either holding them or exchanging them for goods and services. Users also “mine” Bitcoins by tapping their computer’s processing power to solve a computer algorithm, but via the algorithm there is a cap on the supply of Bitcoins.

Virtues or Vices?

But the virtues that many see in Bitcoin — especially its lack of regulation — are exactly what many corporate treasurers and investors view as the currency’s faults. “Bitcoin is not run by a corporation or nonprofit group. In fact, the lack of a central authority means that the Bitcoin payment system is not really run by anyone or anything,” wrote Temple University law student Nikolei Kaplanov in a 2012 paper, “Nerdy Money: Bitcoin, the Private Digital Currency, and the Case Against Its Regulation.”

As a result, according to Kaplanov, “there is no contractual relationship between Bitcoin miners and the creator or provider of the Bitcoin system. Further, unlike virtual worlds that are governed by service agreements, there are no terms of service or any type of user agreements in mining or using Bitcoins.”

The price of Bitcoin has risen significantly in only a few months. “I don’t have a positive view of an unregulated currency being used by corporate treasury departments,” comments Gene Neyer, global payments product manager at vendor Fundtech. “Although there was a small argument made for the [foreign exchange] efficiency of Bitcoin, it pales in comparison to the negatives: namely, finding and dealing with parties that will accept Bitcoin and not having any regulatory dispute resolution under the [Uniform Commercial Code] or similar.” In addition, says Neyer, the boundaries or limits to inflation or deflation of the currency are unpredictable.

Indeed, speculators are jumping into Bitcoin, driving prices to ridiculous heights (see chart, above). The volatility makes Bitcoin an unstable store of value. According to John Bird of Atlas Risk Advisory, a foreign exchange risk consultancy, Bitcoin is not even useful as a hedge. In a test, his firm found that Bitcoin price changes had little or no correlation with price changes of assets such as wheat, corn, oil, the S&P 500, or even the 10-year U.S. Treasury note. The high level of instability in Bitcoin price changes “adds an additional degree of difficulty for the structuring of a Bitcoin hedge,” says Bird.

Building Faith

The Bitcoin community finds the currency’s anarchic roots attractive, but it will have to build faith in the currency’s security and stability to drive adoption. Despite the founder’s wishes, the need for trust — in an issuing authority, or any authority — may be impossible to avoid.

Earlier this year, Mt. Gox, a large, Japan-based Bitcoin exchange that once controlled 85% of Bitcoin trading volume, filed for bankruptcy protection in Japan and the United States after 750,000 Bitcoins deposited by users disappeared. In essence, the incident showed, Bitcoin exchanges like Mt. Gox are almost the equivalent of Bitcoin banks. But if that’s the case, they are unregulated banks at which depositors have neither protection nor insurance against theft and bank runs, as finance expert Aswath Damodaran points out on his blog Musings on Markets.

“While it may conflict with the vision of some Bitcoin revolutionaries, the Bitcoin economy may need a banking system of its own that is regulated and perhaps even insured by a centralized entity,” writes Damodoran, a professor of finance at New York University’s Stern School of Business.

At least for now, traditional banks don’t seem to be eager to jump into the business. For one thing, Bitcoin’s relative anonymity would violate U.S. banking laws that require financial institutions to know their customers. So who is going to build trust in Bitcoin?

Damodaran writes that “Bitcoin’s staying power will ultimately depend upon how impervious its source algorithm is to mischief. … If you are a Bitcoin promoter, you want to make sure that even the slightest doubts that the algorithm can be fudged or modified are dealt with quickly and openly, since those doubts will undo its effectiveness as a currency.”

In addition, while the currency has an advantage in that central banks can’t inflate the value of a Bitcoin on a whim and that there is a technical limit on the number of Bitcoins, someone has to work to keep the value of a Bitcoin relatively stable.

Regulatory Issues

Relying on the Bitcoin community in a kind of “open source” model in which a loosely coordinated group ensures, for example, the algorithm’s security, won’t be enough for most CFOs. Would regulation help? Governments are still grappling with the question of how Bitcoin can and will be regulated. Early on, countries are taking wildly different approaches. Sweden, for one, plans to treat it not like a currency but like a piece of art or an antique, subject to capital gains taxes. Finland’s central bank says Bitcoin is not a payment instrument and is more comparable to a commodity, while Canada’s Revenue Agency equates Bitcoin payments with barter transactions.

In the United States, the director of the Financial Crimes Enforcement Network has said the regulator views virtual currency as a kind of money services business, having the same obligation as other businesses in that industry. In early March, the state of New York started accepting proposals and applications for BitLicenses, a certificate that would allow Bitcoin exchanges to operate in the state. A proposal on the regulatory framework won’t come until the second quarter.

Some lawyers, however, believe Bitcoin users and miners fall outside the regulatory provisions under federal banking, money transmission, and securities laws. According to Nicholas Plassaras, author of “Regulating Digital Currencies,” which appeared last year in the Chicago Journal of International Law, virtual currencies should be regulated like community currencies (also called scrip) because they are issued by a nongovernmental group but have “monetary value accepted for goods and services within the community.”

For companies, of course, the question of monetary value is no small issue: the accounting for and taxation of Bitcoin and Bitcoin transactions are still a mystery. There are no generally accepted accounting principles for Bitcoin, and no official pronouncements yet about accounting methods for Bitcoin from the Financial Accounting Standards Board. The Internal Revenue Service also has yet to weigh in.

In short, many feel like Fundtech’s Neyer does: “Given that the regulations continue to expand, there is just too much reputational risk associated with Bitcoin.”

A Sound Technology

Bitcoin may wither in the face of those challenges, but some experts believe the technology will survive in any event. That’s because, as Netscape co-founder Marc Andreessen has said, “Bitcoin gives us a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer.”

According to Susan Athey, a professor of economics at the Stanford Graduate School of Business, Bitcoin or another virtual currency will become a cheaper way for companies to transfer money internally.

“A company that moves a lot of money cross borders is typically going to wait until the end of the day to net out the transfers … to avoid transaction fees,” Athey says. “It doesn’t want to send money from Country A to Country B and then send it back to Country A the next hour and then pay the fees in both directions, so it waits until the end of the day. But that requires it to hold more capital in each country.”

“If a company could move money all day long in real time for free, then it might move funds more frequently and hold less capital, and that would be cheaper,” says Athey.

Indeed, Ripple, a company Athey is advising, is pitching businesses on just such a service. Ripple is a payment system, currency exchange, and remittance network all in one, and it’s built on a distributed open-source Internet protocol, a Bitcoin-like ledger for recording transactions, and a “native” currency called ripples (XRP).

Bitcoin, meanwhile, is caught in something of a paradox. Regulation threatens the principles on which it was founded, but government involvement may be the only way it becomes a standard form of payment or exchange that is widely accepted. If regulators can figure out what Bitcoin is and confidence in the currency builds, who knows: maybe there will be a currency that, without oversight from a central bank, can offer the security and convenience of traditional money. But Bitcoin is a long way from that.

Vincent Ryan is Editor-in-Chief, Digital Platforms, of CFO.

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